Rising US Treasury yields: Narrative of Inflation or Deficit?

In October, US CPI inflation completely matched market expectations. CPI rose from 2.4% to 2.6% year-on-year, in line with expectations of 2.6%; core CPI remained unchanged at 3.3% year-on-year, in line with expectations of 3.3%. CPI increased by 0.2% month-on-month, while core CPI increased by 0.3%, both consistent with the previous month and expectations. Along with the rise in year-on-year readings, the breadth of CPI inflation rebounded slightly. Looking at the month-on-month breakdown: 1) Food prices rose at a slower rate. 2) A slight adjustment in international oil prices drove gasoline prices down, while electricity prices rose, and energy prices went from falling to flat (0%, previous value -1.9%). 3) Core CPI remained stable at 0.3% month-on-month, showing stickiness. Among them, core goods prices went from rising to flat, decreasing from 0.2% to 0%, returning to historical fluctuations, with clothing prices falling and education and communication prices dragging down, while the increase in prices for used cars expanded (2.7%, previous value 0.3%). Rent growth rebounded from 0.2% to 0.4%, with the main contributions coming from owner's equivalent rent (0.4%, previous value 0.3%) and hotel accommodation (0.4%, previous value -1.9%). Super-core service price growth declined from 0.4% to 0.31% month-on-month. Price increases for transportation services, healthcare services, and public utility services all declined, with entertainment services (0.7%, previous value -0.5%) and other personal services being the main drivers. There is a high probability of a 25 basis point rate cut in December It is expected that there is a high probability of a 25 basis point rate cut by the Federal Reserve in December. On one hand, the trend of inflation still largely aligns with the Federal Reserve's expectations. In the short term, due to base effects and inflation stickiness, the year-on-year CPI for the fourth quarter is expected to rebound slightly, with the core CPI year-on-year staying around 3.3%, reflecting the volatility of the de-inflation process, but the Fed may have already anticipated this scenario (given the change in the November FOMC statement). Before the data was released, Minneapolis Federal Reserve President Kashkari stated that only if inflation exceeds expectations in November and December would they consider pausing rate cuts. On the other hand, since there has not been an unexpected increase in inflation in the short term, and given that the risks to employment remain tilted downwards, the Fed may continue cutting rates to support the job market. After the release of the CPI data that completely matched expectations, the expectation for a rate cut in December increased. The Federal Funds market pricing of a 25 basis point rate cut in December increased from 58.7% to 82.5%, while the probability of no rate cut decreased from 41.3% to 17.5%. US bond yields are rising, how are pricing adjustments made? With CPI completely meeting expectations and the expectation for a rate cut in December increasing, the US ten-year bond yield has risen by about 1.9 basis points. Over the past two months, the US bond yield has increased by about 83 basis points, from a low of 3.62% on September 16 to the current 4.45%. Many views believe that the main driver of the recent rise in US bond yields comes from the narrative of potential secondary inflation risks that may arise from Trump's policies. However, during the same period, the increase in market-traded inflation expectations has been significantly less than the increase in US bond yields. From September 16 until now, the ten-year breakeven inflation rate has increased by about 27 basis points, while the 5-year, 5-year forward inflation rate swap has increased by about 18 basis points. Furthermore, the DKW model from a Federal Reserve working paper suggests that the contribution of the real term premium to the rise in US bond yields has been greater. From September 16 to October 31 (latest data), the ten-year US bond yield increased by about 68 basis points, with the real term premium contributing about 32 basis points, and the combined contribution of inflation expectations and inflation risk premiums being about 21 basis points, while the real interest rate contributed about 14 basis points. The contribution of inflation expectations and inflation risk premiums to the increase in US bond yields is less than that of the real term premium, with the main factor behind the real term premium being supply and demand for US bonds. In Trump's policies, the most direct impact on the supply and demand for US bonds comes from the deficit resulting from tax cuts. In other words, the narrative of "secondary inflation risks" may not be the main reason for the rise in US bond yields, but rather the "deficit narrative." How does the "secondary inflation narrative" differ from the "deficit narrative"? The certainty and persistence of the "deficit narrative" may be higher than that of the "secondary inflation narrative." If US bond yields are being priced based on the former, then the foundation for the prospect of "high for longer" interest rates will be more solid. The increased revenue from Trump's tariff policies may not be enough to compensate for the reduced revenue caused by large-scale tax cuts, leading to a rise in the deficit and federal debt being a more probable event. Although intuitively, Trump's policies such as tariffs, tax cuts, and immigration have strong potential for upward inflation risks, his policies may also bring downward inflation risks: 1) Pressure from falling oil prices. Trump's push to lower oil prices may result in a significant decrease in energy inflation. 2) A comprehensive tariff war leading to a dim outlook for global trade and growth, exerting downward pressure on inflation from the demand side. 3) Defeating inflation is Trump's core promise and ranks first in the 2024 election manifesto. Risk warnings: US inflation and job market exceeding expectations; uncertainty in Trump's policies.